Unit 2

PORTFOLIO THEORY
The Benefits of Diversification

Diversification and Portfolio Risk

Before we look at the formula for portfolio risk, let us understand somewhat
intuitively how diversification influences risk. Suppose you have Rs.100,000 to
invest and you want to invest it equally in two stocks, A and B. The return on these
stocks depends on the state of the economy. Your assessment suggests that the
probability distributions of the returns on stocks A and B are as shown in Exhibit
7.1. For the sake of simplicity, all the five states of the economy are assumed to be
equiprobable. The last column of Exhibit 7.2 shows the return on a portfolio
consisting of stocks A and B in equal proportions. Graphically, the returns are
shown in Exhibit 7.2.

Probability Distribution of Returns

State of the
Economy
1
2
3
4
5

Probability
0.20
0.20
0.20
0.20
0.20

Return on
Stock A
15%
-5%
5
35
25

Return on
Stock B
-5%
15
25
5
35

Return on
Portfolio
5%
5%
15%
20%
30%

Returns on Individual Stocks and the

Portfolio

Relationship Between Diversification and

Risk
Risk

Unique
Risk

Market Risk

10

20

No. of Securities

Market Risk Versus Unique Risk

Basic insight of modern portfolio theory:

Total risk = Unique risk + Market risk

The unique risk of a security represents that portion of it total

risk which stems from firm-specific factors.
The Market risk of a stock represents that portion of its risk
which is attribute to economy wide factors

Portfolio Risk
The risk of a portfolio is measured by the variance (or standard
deviation) of its return. Although the expected return on a portfolio
is the weighted average of the expected returns on the individual
securities in the portfolio, portfolio risk is not the weighted average
of the risks of the individual securities in the portfolio (except when
the returns from the securities are uncorrelated).

Measurement Of Comovements
In Security Returns
To develop the equation for calculating portfolio risk we need
information on weighted individual security risks and
weighted comovements between the returns of securities
included in the portfolio.

Comovements between the returns of securities are measured

by covariance (an absolute measure) and coefficient of
correlation (a relative measure).

Covariance
COV (Ri , Rj) = p1 [Ri1 E(Ri)] [ Rj1 E(Rj)]

+ p2 [Ri2 E(Rj)] [Rj2 E(Rj)]

+

+ pn [Rin E(Ri)] [Rjn E(Rj)]

Illustration
The returns on assets 1 and 2 under five possible states of nature are given below
State of nature Probability Return on asset 1 Return on asset 2
1
0.10
-10%
5%
2
0.30
15
12
3
0.30
18
19
4
0.20
22
15
5
0.10
27
12
The expected return on asset 1 is :
E(R1) = 0.10 (-10%) + 0.30 (15%) + 0.30 (18%) + 0.20 (22%) + 0.10 (27%) = 16%
The expected return on asset 2 is :
E(R2) = 0.10 (5%) + 0.30 (12%) + 0.30 (19%) + 0.20 (15%) + 0.10 (12%) = 14%
The covariance between the returns on assets 1 and 2 is calculated below :

Coefficient Of Correlation
Cov (Ri , Rj)

Cor (Ri , Rj) or ij =

ij

ij
i j

ij = ij . i . j
where ij = correlation coefficient between the returns on
securities i and j

ij = covariance between the returns on securities

i and j
i , j = standard deviation of the returns on securities
i and j

Graphical Portrayal of Various Types of

Correlation Relationships

Dominance Of Covariance
As the number of securities included in a portfolio increases, the
importance of the risk of each individual security decreases whereas
the significance of the covariance relationship increases.